CHAPTER
9
Differential Analysis and
Product Pricing
Warren
Reeve
Duchac
human/iStock/360/Getty Images
Managerial
Accounting
13e
Differential Analysis
(slide 1 of 2)
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Managerial decision making involves choosing between
alternative courses of action.
Although the managerial decision-making process varies by the
type of decision, it normally involves the following steps:
o
o
o
o
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Step 1. Identify the objective of the decision, which is normally
maximizing income.
Step 2. Identify alternative courses of action.
Step 3. Gather information and perform a differential analysis.
Step 4. Make a decision.
Step 5. Review, analyze, and assess the results of the decision.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Differential Analysis
(slide 2 of 2)
•
Differential analysis, sometimes called incremental analysis,
analyzes differential revenues and costs in order to determine
the differential impact on income of two alternative courses of
action.
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o
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Differential revenue is the amount of increase or decrease in revenue
that is expected from a course of action compared to an alternative.
Differential cost is the amount of increase or decrease in cost that is
expected from a course of action as compared to an alternative.
Differential income (loss) is the difference between the differential
revenue and differential costs.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Lease or Sell
•
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Management may lease or sell a piece of equipment
that is no longer needed. In making a decision,
differential analysis can be used.
Only the differential revenues and differential costs
associated with the lease-or-sell decision are included
in the differential analysis.
o
The book value of the equipment is a sunk cost and is not
considered in the differential analysis.
 Sunk costs are costs that have been incurred in the past, cannot be
recouped, and are not relevant to future decisions.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Discontinuing a Segment or Product
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A product, department, branch, territory, or other segment of a
business may be generating losses. As a result, management
may consider discontinuing (eliminating) the product or segment.
Discontinuing the product or segment usually eliminates all of
the product’s or segment’s variable costs such as direct
materials, direct labor, variable factory overhead, and sales
commissions.
However, fixed costs such as depreciation, insurance, and
property taxes may not be eliminated.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Make or Buy
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Companies that manufacture products made up of
components that are assembled into a final product,
such as automobile manufacturers, must decide
whether to make a part or purchase it from a
supplier.
Differential analysis can be used to decide whether to
make or buy a part.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Replace Equipment
(slide 1 of 2)
•
The usefulness of a fixed asset may decrease before
it is worn out.
o
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For example, old equipment may no longer be as efficient
as new equipment.
Differential analysis can be used for decisions to
replace fixed assets such as equipment and
machinery.
o
The analysis normally focuses on the costs of continuing to
use the old equipment versus replacing the equipment.
 The book value of the old equipment is a sunk cost and, thus, is
irrelevant.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Replace Equipment
(slide 2 of 2)
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The revenue that is forgone from an alternative use of
an asset, such as cash, is called an opportunity cost.
Although the opportunity cost is not recorded in the
accounting records, it is useful in analyzing alternative
courses of action.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Process or Sell
•
•
During manufacturing, a product normally progresses through
various stages or processes. In some cases, a product can be
sold at an intermediate stage of production, or it can be
processed further and then sold.
Differential analysis can be used to describe whether to sell a
product at an intermediate stage or to process it further.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accept Business at a Special Price
•
A company may be offered the opportunity to sell its products
at prices other than normal prices.
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For example, an exporter may offer to sell a company’s products
overseas at special discount prices.
Differential analysis can be used to decide whether to accept
business at a special price.
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o
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If the company is operating at less than full capacity, then the additional
production does not increase fixed manufacturing costs.
Fixed costs are not affected by the decision and are, thus, omitted from
the analysis.
However, selling and administrative expenses may change because of
the additional business.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Setting Normal Product Selling Prices
(slide 1 of 3)
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The normal selling price is the target selling price to
be achieved in the long term.
The normal selling price must be set high enough to
cover all costs and expenses (fixed and variable) and
provide a reasonable profit.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Setting Normal Product Selling Prices
(slide 2 of 3)
•
Managers can use one of two market methods to
determine selling price:
o
Demand-based concept
 The demand-based concept sets the price according to the demand
for the product.
– If there is high demand for the product, then the price is set high.
– Likewise, if there is low demand for the product, then the price is set
low.
o
Competition-based concept
 The competition-based concept sets the price according to the price
offered by competitors.
– For example, if a competitor reduces the price, then management
adjusts the price to meet the competition.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Setting Normal Product Selling Prices
(slide 3 of 3)
•
Managers can also use one of three cost-plus methods
to determine the selling price:
o
o
o
Product cost concept
Total cost concept
Variable cost concept
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Product Cost Concept
(slide 1 of 4)
•
Cost-plus methods determine the normal selling price
by estimating a cost amount per unit and adding a
markup, computed as follows:
o
o
Management determines the markup based on the desired
profit for the product.
The markup should be sufficient to earn the desired profit
plus cover any costs and expenses that are not included in
the cost amount.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Product Cost Concept
(slide 2 of 4)
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Under the product cost concept, only the costs of
manufacturing the product, termed the product costs,
are included in the cost amount per unit to which the
markup is added.
Estimated selling expenses, administrative expenses,
and desired profit are included in the markup.
The markup per unit is then computed and added to
the product cost per unit to determine the normal
selling price.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Product Cost Concept
(slide 3 of 4)
•
Step 1. Estimate the total product costs as follows:
•
Step 2. Estimate the total selling and administrative
expenses.
Step 3. Divide the total product cost by the number of
units expected to be produced and sold to determine
the total product cost per unit, computed as follows:
•
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Product Cost Concept
(slide 4 of 4)
• Step 4. Compute the markup percentage as follows:
o
The desired profit is normally computed based on a rate of return on assets as
follows:
• Step 5. Determine the markup per unit by multiplying the markup
percentage times the product cost per unit as follows:
• Step 6. Determine the normal selling price by adding the markup per unit to
the product cost per unit as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Target Costing
(slide 1 of 2)
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•
Target costing is a method of setting prices that
combines market-based pricing with a cost-reduction
emphasis.
Under target costing, a future selling price is
anticipated, using the demand-based or the
competition-based methods.
The target cost is then determined by subtracting a
desired profit from the expected selling price,
computed as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Target Costing
(slide 2 of 2)
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The target cost is normally less than the current cost.
Managers must try to reduce costs from the design
and manufacture of the product.
o
o
The planned cost reduction is sometimes referred to as the
cost drift.
Costs can be reduced by:
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
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Simplifying the design
Reducing the cost of direct materials
Reducing the direct labor costs
Eliminating waste
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Production Bottlenecks
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A production bottleneck (or constraint) is a point in
the manufacturing process where the demand for the
company’s product exceeds the ability to produce the
product.
The theory of constraints (TOC) is a manufacturing
strategy that focuses on reducing the influence of
bottlenecks on production processes.
When a company has a production bottleneck in its
production process, it should attempt to maximize its
profits, subject to the production bottleneck.
o
In doing so, the unit contribution margin of each product per
production bottleneck constraint is used.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Total Cost Concept
(slide 1 of 3)
•
•
Under the total cost concept, manufacturing cost plus
the selling and administrative expenses are included
in the total cost per unit.
The markup per unit is then computed and added to
the total cost per unit to determine the normal selling
price.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Total Cost Concept
(slide 2 of 3)
• Step 1. Estimate the total manufacturing cost as follows:
• Step 2. Estimate the total selling and administrative expenses.
• Step 3. Estimate the total cost as follows:
• Step 4. Divide the total cost by the number of units expected to be
produced and sold to determine the total cost per unit, as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Total Cost Concept
(slide 3 of 3)
• Step 5. Compute the markup percentage as follows:
o
The desired profit is normally computed based on a rate of return on assets as
follows:
• Step 6. Determine the markup per unit by multiplying the markup
percentage times the cost per unit as follows:
• Step 7. Determine the normal selling price by adding the markup per unit to
the cost per unit as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Variable Cost Concept
(slide 1 of 3)
•
•
•
•
Under the variable cost concept, only variable costs
are included in the cost amount per unit to which the
markup is added.
All variable manufacturing costs, as well as variable
selling and administrative expenses, are included in
the cost amount.
Fixed manufacturing costs, fixed selling and
administrative expenses, and desired profit are
included in the markup.
The markup per unit is then added to the variable cost
per unit to determine the normal selling price.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Variable Cost Concept
(slide 2 of 3)
• Step 1. Estimate the total variable product cost as follows:
• Step 2. Estimate the total variable selling and administrative expenses.
• Step 3. Determine the total variable cost as follows:
• Step 4. Compute the variable cost per unit as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Variable Cost Concept
(slide 3 of 3)
• Step 5. Compute the markup percentage as follows:
o
The desired profit is normally computed based on a rate of return on assets as
follows:
• Step 6. Determine the markup per unit by multiplying the markup
percentage times the variable cost per unit as follows:
• Step 7. Determine the normal selling price by adding the markup per unit to
the variable cost per unit as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.